Relationship b/w The Balance Sheet and The Income Statement

1. Topic 5: Relationship b/w The Balance
Sheet and The Income Statement
By: MADDY.KALEEM

2. Agenda
 Transactions that Affect Owner’s Equity
 The Balance Sheet
 The Income Statement
 Statement of Owners’ Equity
 The Accrual Basis of Accounting
 The Cash Basis of Accounting
 Forms of Business Organizations
By: MADDY.KALEEM

3. TRANSACTIONS THAT AFFECT
OWNERS’ EQUITY
 Note that four types of transactions affect owners’ equity:
 1. Owner Contributions,
 2. Owner Withdrawals,
 3. Revenues, and
 4. Expenses.
 Financial Statements:
 All transactions and events for JG&T have now been
properly recorded.
 The accounting records are correct and up to date, so they
can be used to prepare the financial statements.
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4. The Balance Sheet
 The cumulative effect of all transactions and events on the
various equation items is shown in the last two lines of
Exhibit 2-7.
 The balance sheet is prepared by simply rearranging the
numbers so that they appear in the proper format.
 The balance sheet as of January 31 appears in Exhibit 2-8.
 Each item on the balance sheet is often referred to as an
account.
 Note the date on the balance sheet: January 31, 2000.
 All balance sheets summarize a firm’s assets, liabilities, and
owners’ equity at a discrete point in time.
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5. The Balance Sheet
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6. The Income Statement
 The income statement summarizes a firm’s revenues and expenses
for a period of time.
 Net income is computed by subtracting expenses from revenues.
 JG&T ’s income statement for the month of January appears in
Exhibit 2-9.
 The income statement is prepared by compiling information from
the owners’ equity account.
 Recall that all revenue transactions increase owners’ equity and that
all expense transactions reduce owners’ equity.
 This makes owners’ equity a convenient place to look for
information about revenues and expenses.
 To help you see that JG&T ’s income statement summarizes its
revenue and expense transactions for the month of January, Exhibit
2-10 summarizes all of JG&T ’s transactions for that month.

7. The Income Statement
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8.  The income statement provides financial statement readers
with information about the profitability of the organization
for a past period of time.
 It indicates how successful the organization was in
generating revenues and controlling costs.
 During January, JG&T earned a net income of $289.
 Although this amount might not seem very impressive in
light of total revenues of $4,650 and an investment of
$50,000 by Harry, January was JG&T ’s first month of
operation.
 Simply operating above break-even (a zero profit or loss) is
an accomplishment.
The Income Statement
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9.  Within the context of a large corporation, an income statement can
also be thought of as a report on management’s performance.
 One of management’s major responsibilities is to enhance shareholder
wealth.
 Managers serve as agents of the shareholders, and they must be held
accountable for their performance.
 Because profitable operations are essential to adding value to the firm,
the income statement can be used to assess how well managers have
performed.
 Reported net income is an extremely useful figure to investors and
plays a major role in their decisions.
 To illustrate, when Nordstrom Inc. reported healthy second-quarter
earnings, the value of the company’s stock surged $4.34 per share
(14%).
 On the other hand, Adobe Systems’ stock fell $3.44 per share (11%) on
the day it warned of a possible small loss for its third quarter.
The Income Statement
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10.  Note that income statements are prepared for periods of time,
usually a month, quarter, or year.
 Income must be related to a specific period of time to be
interpretable.
 For example, assume that you apply for a job and are told the job
pays $5,000.
 An evaluation of the job’s desirability would be impossible
without knowing if you would earn $5,000 per week, month,
year, or some other time period.
 For this reason, the income statement in Exhibit 2-9 contains the
caption “For the Month Ended January 31, 2000.”
 Many firms prepare income statements for calendar years, that
is, for the period January 1 through December 31.
The Income Statement
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11.  Other firms use 12-month periods that do not end on
December 31.
 These firms usually select an ending date that
corresponds to a low point in their activity.
 For example, many clothing stores, such as the Gap,
have fiscal years that run from February 1 through
January 31.
 January 31 is selected as the end of the fiscal year
because it shortly follows the busy holiday period and
provides time for refunds and exchanges to take place.
The Income Statement
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12. Statement of Owners’ Equity
 In addition to the balance sheet and the income statement,
firms also prepare a statement of owners’ equity.
 This statement summarizes the changes that took place in
owners’ equity during the period under review.
 Because investments and withdrawals by the owners affect
owners’ equity, they appear on this statement.
 Revenue and expense transactions also affect owners’
equity.
 Instead of listing each revenue and expense transaction
separately, their difference (net income) is included in the
statement of owners’ equity.
 Exhibit 2-11 contains JG&T ’s statement of owners’ equity
for the month of January..
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13.  Now refer back to Exhibit 2-10.
 As you can see, the statement of owners’ equity
reflects all of JG&T ’s transactions that affected
owners’ equity.
Statement of Owners’ Equity
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14. Relationship Between the Balance
Sheet and the
Income Statement As you know, the balance sheet reports assets, liabilities, and owners’
equity at a moment in time.
 The income statement summarizes revenue and expense transactions
that occur during a period of time.
 Since revenue and expense transactions affect owners’ equity, net
income explains most of the change that takes place in owners’ equity
during a period.
 Contributions and withdrawals by owners also affect owners’ equity.
 Thus, the change in owners’ equity is explained by net income, owner
contributions, and owner withdrawals.
 Because owners’ equity must equal assets minus liabilities (net
assets), the changes in one side of the equation must equal the changes
in the other side.
 Therefore, changes in net income, owner contributions, and owner
withdrawals also explain changes in net assets.
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15. THE ACCRUAL BASIS OF
ACCOUNTING
 An important aspect of a financial accounting system is the
decision about when to record revenue and expense
transactions.
 Recording a transaction in the accounting records is
referred to as recognition.
 Consider JG&T ’s first revenue transaction in January.
Customers were given golf lessons and charged $600.
 The customers paid $200 in January and promised to pay
the remainder in February. (Keep in mind our assumption
that the customers will honor this pledge.)
 There is little argument that at least $200 of revenue should
be recorded in January.
 But when should the other $400 be recorded?
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16.  In January when the services were provided, or in
February when the cash is ultimately collected?
 The accrual basis of accounting records revenues
when goods or services have been delivered or
provided, regardless of when cash is received.
 At the time of rendering the service, JG&T has earned
the revenue; the entire $600 is recognized as revenue
at that time under the accrual basis.
 All of JG&T ’s previous transactions have used the
accrual basis.
THE ACCRUAL BASIS OF
ACCOUNTING
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17. THE CASH BASIS OF ACCOUNTING
 The cash basis of accounting records revenue
when cash is received.
 Under that approach, JG&T recognizes $200 of
revenue in January and $400 of revenue in
February.
 Let’s evaluate these two approaches.
 Which provides the most useful information to
financial statement readers?
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18. Accruals vs. Cash BASIS
 If the income statement is viewed as providing information
about increases in a firm’s wealth, the accrual basis seems
to be the preferable approach.
 In January, JG&T received not only $200 in cash, but also
the right to receive $400 in the future. Recording $600 of
revenue in January is appropriate.
 Income statements can also be viewed as reports on a firm’s
performance.
 Which number, $600 or $200, is a better indicator of JG&T
’s accomplishments in January?
 Because $600 of golf lessons were provided in January, $600
seems a better measure of accomplishment (or
performance).
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19.  Now consider one of JG&T ’s expense transactions.
 During January, $120 of utility services were consumed.
 This amount will be paid in February. Should a $120
expense be recorded in January or February?
 The accrual basis records expenses when resources are
consumed (regardless of when payment is made), while the
cash basis records expenses when the cash is actually paid.
 The utility’s services were used in January, and the accrual
basis would record the $120 as an expense in that month.
 The cash basis would defer recognition until JG&T pays the
utility company in the following month.
Accruals vs. Cash BASIS
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20.  Again, let’s evaluate the usefulness of the information
produced by the two approaches.
 Consumption of the utility services took place in January.
 At that time, the firm’s liabilities increased, and its net
worth decreased.
 This reduction in the firm’s value should be reflected in
January’s income statement; the accrual basis would do
this.
 Moreover, in measuring a firm’s performance, all resources
consumed in generating revenue should be shown on the
same income statement as that revenue.
 Accountants refer to this as the matching principle.
Accruals vs. Cash BASIS
By: MADDY.KALEEM

21.  The utility services were consumed in January to help
generate the revenue reported on January’s income
statement.
 Accordingly, the accrual basis provides a better portrayal of
a firm’s performance.
 GAAP requires the use of the accrual basis, yet as
previously discussed, cash flow information is also
important to financial statement readers.
 Accordingly, GAAP also requires the statement of cash
flows.
 Also note that some small businesses, which do not need
audited financial statements, use the cash basis.
Accruals vs. Cash BASIS
By: MADDY.KALEEM

22. FORMS OF BUSINESS
ORGANIZATION
 Financial accounting is used by a wide variety of
organizations, including businesses organized to earn
a profit, nonprofit organizations, and governmental
entities.
 Our focus is on profit-oriented enterprises, which can
be organized in one of the four ways described below.
1. Sole Proprietorships
2. Partnerships
3. Corporations
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23. Sole Proprietorships
 Sole proprietorships are businesses that are owned by
one individual and usually operated by that individual.
 They are not separate legal entities apart from the
owner, and no special legal steps are required to
launch or operate this form of business.
 Our working example of JG&T’s business, owned by
Harry Jacobs, would probably be organized as a sole
proprietorship.
 As another example, if you decided to earn money by
doing Gardening during the summer, your business
would probably be organized as a sole proprietorship.
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24.  Because no legal procedures are needed to begin operating sole
proprietorships, their primary advantage is ease of formation.
 The major disadvantage is unlimited legal liability.
 Because owners are not legally distinct from their businesses, any
claims against sole proprietorships are also claims against the owners’
personal assets.
 Although sole proprietorships are not separate legal entities, they are
separate accounting (or economic) entities.
 The entity assumption indicates that the actions of the owner, serving
as an agent of the business, can be (and should be) separated from the
personal affairs of the owner.
 Based on this distinction, information about the transactions of the
business can be accumulated via the financial accounting process.
 This enables the owner to assess the status and performance of the
business on a stand-alone basis.
Sole Proprietorships
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25. Partnerships
 Partnerships are very similar to sole proprietorships,
except that partnerships have more than one owner.
 Partnerships are not separate legal entities apart from
their owners, but they are separate accounting entities.
 They are almost as easy to form as sole proprietorships,
yet because of multiple owners, care must be taken to
specify the rights and responsibilities of each owner.
 This is usually done in a partnership agreement, which
is a legal contract among the partners.
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26. Corporations
 Corporations differ substantially from sole proprietorships
and partnerships because they are separate legal entities.
 They are granted their right to exist by the individual
states.
 A corporation must
 develop bylaws governing its operation,
 issue stock to its owners (shareholders) to represent their
ownership interests,
 elect a board of directors who are responsible for the
management of the corporation,
 pay taxes, and
 adhere to a variety of laws and regulations.
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27.  Most large and many smaller businesses are organized as corporations.
 As might be expected, forming a corporation is a relatively
cumbersome and expensive process.
 Costs include filing fees paid to the state of incorporation, legal fees,
and amounts paid for corporate records, such as stock certificates,
bylaws, and so on.
 Corporations, unlike sole proprietorships and partnerships, must pay
income taxes.
 Moreover, shareholders are also taxed on any dividends paid to them.
 Thus, corporations are subject to double taxation.
 Because sole proprietorships and partnerships are not separate legal
entities, they do not pay income taxes; sole proprietors and partners
include the income of their businesses on their individual income tax
returns.
Corporations
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28.  The corporate form of organization has certain
advantages that can outweigh the costs.
 Perhaps the primary benefit is the limited liability
offered to shareholders.
 Because the corporation is a legal entity, the
corporation itself is responsible for its actions.
 Although shareholders risk losing their investment,
their personal assets are protected from claims against
the corporation.
 Such is not the case for sole proprietorships and
partnerships.
Corporations
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29. Hybrid Forms of Organization
 Many states are now offering forms of organization
that combine certain characteristics of partnerships
and corporations.
 These forms include professional corporations, limited
liability companies, and limited liability partnerships.
 Although an evaluation of the advantages and
disadvantages of these forms of organization is beyond
our scope, keep in mind that careful consideration
must be given to this issue when starting a new
business.
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30. Accounting Implications
 The accounting differences among these three
organizational forms lie mainly in the Owners ’equity
section of the balance sheet.
 The accounting for partnerships is very similar to that
for sole proprietorships.
 Because each partner is an owner, each partner has a
capital account where his or her interest in the firm is
shown.
 The accounting for corporations is slightly more
complex.
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31. ACCOUNTING FOR CORPORATIONS
 Two differences exist in the accounting for owners’
equity in corporations.
 First, because shareholders are the owners of the
corporation, this section is called shareholders’ equity.
 Second, the shareholders’ equity section is divided
into two sub categories.
 One category is invested capital. It reflects the
shareholders’ interest in the firm that arises from
direct contributions by the shareholders.
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32.  If Harry Jacobs had formed a corporation when he
started his golf and tennis shop, for example, his initial
investment would be recorded by increasing both cash
and the invested capital part of shareholders’ equity.
ACCOUNTING FOR CORPORATIONS
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33.  The other category of shareholders’ equity is retained
earnings.
 This section contains the effect of revenue and expense
transactions on shareholders’ equity.
 That is, it reflects the increase (or decrease) in the
shareholders’ interest in the firm that arose from
operations since the firm’s inception.
 Consider again transaction (10) from earlier.
 Inventory that was previously purchased for $2,200
was sold, on account, for $4,000.
ACCOUNTING FOR CORPORATIONS
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34.  The only change in the analysis for a corporation is
that the retained earnings component of shareholders’
equity reflects the effect of this transaction on the
shareholders’ interest in the firm.
ACCOUNTING FOR CORPORATIONS
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